Is OPEC aiming for a higher price?

Cartel appears set to cut output and ready to defend $60 price floor

SAN FRANCISCO (MarketWatch) -- Members of the Organization of the Petroleum Exporting Countries will meet next week and they appear ready to set a floor for prices amid worries of weakening demand from a slowing U.S. economy.

Officials from the cartel have voiced support for a production cut, just two months after 10 of its 11 members agreed to cut output by 1.2 million barrels a day.

What's surprising to many experts is that OPEC is planning to cut output at a time when overall demand for oil is growing.

OPEC is 'finding that demand has not been destroyed at these [price] levels, so they think the world can afford it.'
Phil Flynn, Alaron Trading

While OPEC may be seeking a higher target for oil prices, the trick will be to balance oil at a price that doesn't destroy demand.

A decision for a reduction in output would probably come "mainly because [members] are worried about building inventories," said Phil Flynn, a senior analyst at Alaron Trading in Chicago.

But OPEC is "finding that demand has not been destroyed at these [price] levels, so they think the world can afford it," he said.

OPEC members, excluding Iraq, agreed at a meeting in October to reduce production to 26.3 million barrels a day, starting Nov. 1, from output levels of around 27.5 million barrels.

Last week, OPEC President Edmund Daukoru said the group may decide to cut production by an additional 500,000 barrels a day when it meets Dec. 14 in Nigeria.

"Right now, a half a million barrel-per-day cut is the odds on favorite outcome -- and that number is in the name of 'market stability'," said Edward O'Connor, president of energy-trading and brokerage-services provider Optionable Inc.
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Tackling demand

U.S. demand for petroleum products rose 1.7% over the last four-week period, compared with a year ago. Gasoline demand rose 1.6% and distillate-fuel demand rose 6.6%, according to Energy Department data for the week ended Nov. 24.

And the International Energy Agency has said global demand for oil products will grow by 1.1% this year, compared with last year.

Global demand is growing so "the real reason for the OPEC-cut talk is to keep prices as high as possible without jeopardizing throwing the global economy into a recession and tripping the inflation figures," said John Person, president of National Futures Advisory Service.

O'Connor said the IEA's data show "pretty flat demand" for the second and third quarter of 2007, while third-quarter oil inventories this year climbed.

"Even if OPEC underestimates demand, the perception is that the delicate balance of global growth is not jeopardized by crude prices in the $60s and maybe even in the $70s," he said.

If higher prices do end up stifling growth, "Saudi Arabia will act as the swing producer and let some extra production into the marketplace," he said.

For now, that's unlikely, with prices for the front-month crude futures contract losing 20% from their peak in mid-July, to close Thursday at $62.49.

Influencing price

A 2006 Atlantic hurricane season that was much quieter than expected was key to the price decline, as was steady oil production in the Mideast. See a related Commodities Corner.

However, economic data point to a slowdown in the U.S. economy and have hit the dollar hard, pushing it to a 20-month low against the euro, and a 14-year low against the British pound last week.

OPEC is worried about the drop in the value of the dollar, which makes the dollar-denominated oil price appear lower to the oil producers, said Flynn.

The value of the dollar has seen a sharp drop since the end of August, said Rakesh Shankar, an economist at Moody's Economy.com. "This is eroding the purchasing power of OPEC member countries in Asia, where the value of the dollar has fallen by higher than it has versus the euro."

The decline in purchasing power is "just one more reason why OPEC members will support a higher dollar price for oil," said Shankar.

He said the cartel will cut production by about 1 million barrels a day because the members' decision will be "more about shoring up OPEC credibility," than "shoring up the oil price."

'The only thing between [OPEC member's] public statements and a new $70 target price is that they are no yet convinced the market will support that high of a price.'
Charles Perry, Perry Management

OPEC will be looking to target inventory levels to make sure supplies don't get too high, instead of targeting price, which is driven by "too many speculative forces," said Shankar.

Still, OPEC appears to be happy with $60 oil and there has been "dissension in the ranks, from Kuwait and Algeria, saying [that] at $63, oil prices are high enough," he said.

Flynn said the cartel wants to "defend $60 a barrel as a floor" for prices.

James Williams, an economist at WTRG Economics, said OPEC is probably aiming for $57 or $60 for crude prices, with its price target for the OPEC basket of 11 types of crude oils likely at $50.

Big burden

Either way, OPEC has a hefty burden to carry.

"Prices have stabilized in response to their last cut, but the organization worries that inventories will move higher without another cut," said Michael Lynch, president of Strategic Energy & Economic Research.

Then again, "cutting production when prices are so high will be wildly unpopular with the consuming nations," Lynch said.

In short, "OPEC is looking to capture as much money from oil and balance a potential for the bottom falling from under current prices due to macro-economic forces," said National Futures' Person.

"The balance is [for OPEC members] to find the best price possible that the market can handle without becoming their own worst enemy," he said. And the $57 to $65 range "seems to be something the world is comfortable with."

Still, "the only thing between [OPEC members'] public statements and a new $70 target price is that they are not yet convinced the market will support that high of a price," said Charles Perry, chairman of energy-consulting firm Perry Management.

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